Venezuela highlights need to focus on recovery risk

With Venezuela in the midst of a political and economic crisis, this is highlighting the need for investors to not only focus on default risk in fixed income, but also recovery risk, says Hamed Faquiryan, vice-president in the fixed income and multi-asset class research team at MSCI Inc.

Although there are numerous issues, people who own Venezuelan fixed income must worry about the quality of its attached collateral and how that price dynamic will evolve as the political situation continues to unfold, he says.

“You have to think about what you can get in terms of what you’re entitled to as an investor and the collateral that a sovereign has and then how long you will have to wait to get it.”

The state oil company Petróleos de Venezuela, also known as PDVSA, has defaulted on most of its USD-denominated bonds and so has the state, so the risk of a default isn’t as big of a consideration as the recovery risk, notes Faquiryan.

“The way we generally think about a credit instrument is, I’m entitled to a series of cash flows, and then my principal payment at the end for giving the issuer money immediately. And there are two broad risks, which [are]: I’m not going to get the money that’s owed to me, and if I don’t get that money that’s owed to me in terms of the cash flows that were promised in the contract, then what will I get in terms of trying to recover some value?”

Referring to the example of a company that owns equipment and defaults, Faquiryan notes the investor can either keep the equipment or try to sell it. But in the case of a sovereign bond, if there’s a default, it’s less obvious what the investor can get from the assets, he says. “That’s an extremely uncertain prospect just because there is a fluid situation in Venezuela in terms of both who’s in charge and who has the power to pay back bondholders.”

MSCI is developing a new credit framework focused on recovery risk, Faquiryan says.

“Before, all the risk estimation was really just focused on estimating default probabilities. And now I think we realized that recovery is not important until it’s extremely important and we’re trying to fill that gap now.”

Previously, MSCI could, at a high level, infer default probabilities from market prices and then assume how much an investor would get in case of a default, he explains. However, even when considering market prices for distressed or defaulted issuers, there’s still volatility. And assuming there’s just one number in a default situation underestimates risk because recovery is a risk factor as well.

“Just having a single value is the real issue. It just undermines your own exposure to market movements.”